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A Model of Capital and Crises

  • Arvind Krishnamurthy

    (Northwestern Kellogg)

  • Zhiguo He

    (Chicago Booth)

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    We develop a model in which the capital of the intermediary sector plays a critical role in determining asset prices. The model is cast within a dynamic general equilibrium economy, and the role for intermediation is derived endogenously based on optimal contracting considerations. Low intermediary capital reduces the risk-bearing capacity of the marginal investor. We show how this force helps to explain patterns during financial crises. The model replicates the observed rise during crises in Sharpe ratios, conditional volatility, correlation in price movements of assets held by the intermediary sector, and fall in riskless interest rates. In a dynamic context, we show that aversion to drops in intermediary capital can generate a two-factor asset pricing model with a role for both a market factor and a liquidity factor.

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    Paper provided by Society for Economic Dynamics in its series 2009 Meeting Papers with number 85.

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    Date of creation: 2009
    Date of revision:
    Handle: RePEc:red:sed009:85
    Contact details of provider: Postal: Society for Economic Dynamics Marina Azzimonti Department of Economics Stonybrook University 10 Nicolls Road Stonybrook NY 11790 USA
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    8. Xavier Gabaix & Arvind Krishnamurthy & Olivier Vigneron, 2005. "Limits of Arbitrage: Theory and Evidence from the Mortgage-Backed Securities Market," NBER Working Papers 11851, National Bureau of Economic Research, Inc.
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